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Morningstar | FVE Increase: Diamondback Lowers Drilling Costs and Extends Permian Footprint. See Updated Analyst Note from 10 Aug 2018

We think Diamondback Energy is a rare gem in the overvalued oil and gas sector. In our view, the market has been spooked by pricing jitters related to Permian pipeline congestion, and isn’t giving enough credit for the company’s substantial and sustainable cost advantage. To be sure, it does have more exposure to weakening Midland prices than many of its peers, even after scrambling to set up firm transport agreements to lock in Gulf Coast prices for the majority of its production in the next 18 months. But it does have comprehensive gathering in place, and by 2020 it will have secured 225 thousand barrels per day of firm capacity on long-haul pipelines to the Gulf Coast, eliminating basis risk entirely. Until then, it will have to cope with steep discounts to West Texas Intermediate ($12-$16 in the back half of 2018 and $2-$6 in 2019, according to new guidance from management). But even after incorporating these weak realizations and our own bearish outlook for long-term crude prices, we see substantial upside in the stock.

After reviewing the firm’s second-quarter earnings release, we increase our fair value estimate to $157 per share from $137. The increase was driven by multiple factors, including the plan to add two additional rigs in the back half of 2018. In addition, management notes that owing to the use of regional sand, the firm has gotten its Midland Basin drilling and completion cost down to $765/ft. Previous guidance for this item in 2018 was $760-$810, and we conservatively assumed $900/ft to capture unexpected service cost inflation. Bear in mind that regional sand is not yet being used in the firm's Delaware operations, so there is scope for further cost reductions.

Still, the acquisition of Ajax Resources was the main driver of our increased valuation. We value the purchased assets--25,000 net acres in the northern Midland Basin--at just under $2 billion, assuming a steady one-rig program. This clearly exceeds the $1.2 billion consideration.

To get to that number, we assume the following average well parameters: lateral length of 9,500 feet, 90-day initial production rate of 1,140 boe/d, estimated ultimate recovery of 1,100 mmboe, capital cost of $7.3 million, and an initial oil cut of 81%. All of that is in line with, or slightly more conservative than, previous and offset operator results (as well as Diamondback forecasts). The acquired acreage slots neatly among the company's existing holdings in Andrews and Midland Counties, and as the combined position is more contiguous, it should unlock additional value by enabling longer laterals. The traditional Midland Basin "sweet spot" is further south of this area, but the array of wells drilled thus far (across three reservoir zones) gives us confidence that this area can compete for capital in Diamondback's portfolio. This is further supported by management commentary that 220 of Ajax's 362 potential drilling locations are now in the top quartile of the combined firm's inventory. High-quality acreage has always been a central pillar of our thesis on Diamondback, as it is the source of the firm's impressive cost advantage, which underpins our narrow moat rating. By bolting on further leasehold of an equivalent quality, it has extended its runway of low-cost drilling opportunities.

Finally, we note that the acquisition was not particularly cheap by conventional metrics ($23,000/acre assuming $55,000 per flowing boe for the 12.1 mboe/d current production). Yet it immediately added $750 million ($7.40 per share) to our net asset value estimate. Diamondback's ultra-low cost structure is the solution to this paradox. Essentially, the firm paid a reasonable price for the asset but will unlock additional value over time by developing it more cheaply. Our estimates assume that basis differentials for oil will be back under $3/bbl by 2020, and that the firm can keep its unit operating expenses flat at $9.39/boe in real terms (among the lowest in our coverage). That makes the stock look attractive, even after factoring in our bearish midcycle forecast of $55/bbl for WTI crude. For reference, with a midcycle assumption of $60/bbl, our valuation would increase to $179/share.